Baker Hughes' Cash Flows, Capex Worrisome For Company

Baker Hughes Inc (NYSE:BHI) is the third largest oilfield services company in the U.S., with a market cap of $20.3 billion. The company provides oilfield services, technology, products and systems to the global Oil and Gas Industry. BHI is also involved in the supply of industrial and other products and services to the downstream and midstream segments of the Oil and Gas Industry. BHI has operations in more than 80 countries and conducts its business through affiliates, ventures and subsidiaries.

Earnings and Revenue Drivers

The revenue and profitability of the company are dependent on the operating and capital expenditures incurred by the Exploration and Production (E&P) sector for the exploration, drilling and production of oil and natural gas. These expenditures are dependent on the future price expectations of oil and natural gas prices, demand for oil and gas, which is a function of economic growth, and production estimates of oil and natural gas in the present and in the future.

Earnings Review

BHI reported revenue of $5.33 billion in 2Q2012, witnessing an increase of 12% compared to the same period last year. About 66% of the revenue was generated through services, while the rest was through sales. Operations in North America generated oilfield revenue of $2.67 billion in the second quarter of 2012, which increased by 12% compared to the second quarter of 2011. The revenue from North America increased, driven by increased service intensity and activity in the Gulf of Mexico and onshore the U.S., through drilling for oil in unconventional reservoirs. This increased drilling for oil plays was due to the record low prices of natural gas in North America and better profitability offered in oil production.

Oilfield revenue generated through operations outside North America was recorded at 2.33 billion for the second quarter of 2012, showing an increase of 12% compared to the same period last year. The increase in revenue was driven by increased activity in Africa, Europe and Middle East.

$ Million

2Q2012

2Q2011

% change

Revenue

North America

2,672

2,372

12.65%

International

2,654

2,369

12.03%

Total

5,326

4,741

12.34%

BHI reported 2Q2012 earnings per share of $1, showing an increase of 7.5% compared to EPS of $0.95 in the second quarter of 2011, and an increase of 16.3% sequentially. EPS for the second quarter also beat mean earnings per share expectations of $0.77, showing a deviation of 30.6%.

Operations in North America witnessed their profitability being affected negatively due to higher supply of pressure pumping capacity in the market, and higher raw material and personnel costs of pressure pumping, while the demand for upstream chemical, artificial lift, completions and drilling services increased, as compared to the same period last year. International operations witnessed an increase in profitability due to higher activity in Africa, Europe and the Middle East, in the second quarter of 2012, compared to the second quarter of 2011.

The cash flow from operating activities witnessed a decline of 69% in the second quarter of 2012, as compared to the previous quarter, due to a change in net operating assets and liabilities, which reduced the cash generated from operations.

CAPEX witnessed an increase of 41% in the second quarter of 2012, as compared to the same period in the previous year. Even though most of the CAPEX is incurred to acquire machinery and equipment, the company has continued to spend on the expansion of existing facilities, new facilities and other infrastructure projects.

$ Million

1H2012

1H2011

% change

Cash flow from operating activities

124

397

69%

Capital expenditures

(1,442)

(1,023)

41%

Drilling Activity

Upstream spending on natural gas projects witnessed a decline. However, spending on oil projects increased the rig count in North America by 7% in the second quarter of 2012, as compared to 2Q2011. Drilling for oil projects increased 42%, while drilling activity for natural gas projects witnessed a decline of 32% in the second quarter of 2012, compared to 2Q2011, which as mentioned above was due to the depressed prices of natural gas in North America triggered by excess supply in the region.

Upstream spending in international markets is influenced primarily by Brent oil prices. The Brent prices declined 7% in the second quarter of 2012, compared to the same period in the previous year, due to the debt crisis engulfing Europe and the concerns of a slowdown in economic activity in China. Nevertheless, upstream spending increased as a result of higher activity, driven by long term planning cycles of operators.

2Q2012

2Q2011

Average Prices for the period

Brent oil prices ($/Bbl) (1)

108.95

116.81

WTI oil prices ($/Bbl) (2)

93.42

102.34

Natural gas prices ($/mmBtu) (3)

2.29

4.38

Rig count

2Q2012

2Q2011

% change

U.S. - land and inland waters

1,924

1,795

7%

U.S. - offshore

47

31

52%

Canada

177

187

-5%

North America

2,148

2,013

7%

Latin America

438

417

5%

North Sea

41

38

8%

Continental Europe

76

74

3%

Africa

90

76

18%

Middle East

343

291

18%

Asia Pacific

241

251

-4%

Outside North America

1,229

1,147

7%

Worldwide

6,754

6,320

7%

Demand for Hydrocarbons and Upstream Spending

Demand for hydrocarbons is expected to grow throughout 2012 as compared to the previous year. The higher demand for hydrocarbons is expected to be driven by higher demand for natural gas in Asia and North America.

Asia is expected to increase its natural gas due to increased energy demand in China and India because of their economic growths. Japan is also expected to continue to contribute towards the increased natural gas in the form of liquid natural gas ((NYSEMKT:LNG)), as it decreases its dependency on nuclear energy.

Demand for natural gas in North America is also expected to remain strong, driven by low prices of natural gas and a hot summer in North America.

The Brent oil and Western Texas Intermediate oil ((NYSE:WTI)) are currently hovering at their levels to make it feasible for operators to continue exploration and production of crude oil in North America and internationally.

Outlook

The aforementioned factors will increase the upstream expenditure incurred by Exploration and Production (E&P) companies, which is beneficial for the oil services companies such as Baker and Hughes going forward.

BHI is currently trading at P/E, P/B and P/S multiples 12.5x, 1.3x and 1.04x, and offers a dividend yield of 1.28%, which is on the higher side compared to its close peers.

However, we highlight that the cash flow from operations and the CAPEX are a cause for concern for the company. We believe there are opportunities within the sector that are offering similar upside potential with less risk and strong valuations.

Therefore, we have a neutral stance on the stock.

We have also highlighted two such companies, namely Schlumberger Ltd (NYSE:SLB) and Halliburton Co (NYSE:HAL), and links to our previous reports on the companies have been given below:

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